Originally published in THE BOSTON GLOBE
Tuesday, November 10, 1998
"It's imperative to save Latin America's largest economy"
Averting Crisis in Brazil
Martin and Kathleen Feldstein
The gathering financial storm that began in Thailand almost 18 months ago and that spread rapidly to other emerging market countries is stalled off the coast of South America. When the crisis first threatened Brazil in 1997, the government raised real interest rates sharply to more than 30 percent. That successfully spared Brazil the financial collapse that occurred in Southeast Asia, but at a high cost to the economy in terms of sharply slower growth. Even so, the risk of a major upheaval reemerged this past summer with the deepening of the global crisis.
As we write, the G-7 governments and the international financial institutions are developing a plan to give financial aid to Brazil to reduce the risk of a run on the Brazilian currency. Brazil is a particularly interesting case because it finds its currency under attack despite having pursued many sound policies. Because of its size and its importance in Latin America, foreign governments including our own are eager to prevent a currency crisis and economic collapse that could spread through the region
Brazil is the world's eighth largest economy and the largest economy of Latin America with a GDP of $800 billion and a population of 165 million. That's nearly twice the population of Mexico and five times that of Argentina. What happens in Brazil will have broad implications for the economies of the entire region.
Until the leadership of Fernando Cardoso, the Brazilian economy was both lethargic and racked by a hyperinflation that exceeded 1000 percent in 1994. As Finance Minister and more recently President, Cardoso introduced the Real Plan (pronounced ray-ahl, the "real" is the Brazilian currency) which has brought Brazil's inflation rate to less than five percent in the last year. Foreign trade has already been liberalized along the very lines that the G7 countries advocate.
But the Cardoso program, which has also included a gradual devaluation of the real against the dollar, was not enough to avoid another crisis this summer when international speculators as well as Brazilians began to sell the Brazilian currency.
Why did the Brazilian currency come under attack in this way? A key statistic to watch in order to understand currency speculation is a country's current account balance, which combines the trade deficit with the net interest and dividends paid to foreigners. This year Brazil's current account deficit has been running at nearly 4% of GDP.
The large deficit in Brazil's current account means that Brazil is spending more for imports and net interest on its debt to foreigners than it receives from selling its exports. A large current account deficit is a signal that a currency may be overvalued and thus vulnerable to a speculative attack. Experience around the world shows that a country cannot sustain a deficit as large as Brazil's for long.
With large enough foreign currency reserves, a country can finance a current account imbalance temporarily by running down its reserves. But that too cannot be sustained when speculators bet against a currency, as Brazil has found recently when it has lost as much as $1 billion in foreign reserves in a single day.
When orderly and gradual, a currency devaluation may make exports more competitive in international markets and raise the cost of imports from abroad. At some level of the exchange rate, the trade balance is restored and the speculators lose interest. But a rapidly falling currency can be destabilizing at home, creating inflationary pressures and undermining confidence in the government's economic policies. That's why the Brazilians are rightly resisting the big currency devaluation that some are urging on them.
To reduce the current account deficit and prevent massive capital flight, Brazil must first solve the fundamental problem of its overall government budget deficit. Because of Brazil's sky-high interest rates, the interest that the government must pay on the Brazilian public debt is now 7 percent of GDP. Although tax revenues pay for all of the rest of Brazilian government spending, the interest bill alone leaves Brazil with a budget deficit equal to 7 percent of GDP.
If Brazil succeeds in cutting government spending by about three percent of GDP, as President Cardoso has pledged, the likely result would be a restoration of confidence that permits a sharp reduction in the interest rates that the government must pay on its debt. The combination of the spending cuts and the lower interest rates could bring the budget back close to balance.
Virtually eliminating the budget deficit would bring down Brazil's need to borrow from abroad. The current account deficit would disappear or be sharply reduced and the threat to the "real" would be checked.
How this plays out depends almost entirely on Brazilian Congressional politics. Despite Cardoso's own electoral mandate and the success of several governors who support him, the president does not control Congress. There is substantial opposition to Cardoso's plan to cut government spending and the outcome of the legislative process is currently unclear.
The likely assistance package that Brazil has been negotiating with the IMF and the G-7 might help to buy time while the Brazilian government introduces reforms. But restoring confidence for the long haul is up to Brazil. If Brazil succeeds in cutting the budget deficit, the crisis can be avoided. If the Cardoso plan fails, no amount of U.S. and international assistance will be sufficient to resist a sustained run on the Brazilian currency.
Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.